Big week for central banks

0:06Pushkin. Central banks have inarguably been the most important force in the global economy in the global economy is going to go. If you are a close watcher of the markets, this week matters. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio, joined as ever on Tuesdays by the woman who has seen more ECB press conferences than any FT staff or potentially any human being in history other than Christine Lagarde, FT Markets editor Katie Martin. Well, you know, that's not true, but I'm prepared to go with it. I've certainly watched an awful lot of European Central Bank press conferences to the point where I had a pretty encyclopedic knowledge of which tie the former European Central Bank president Mario Draghi had worn to which press conference and what market reaction came after each of them.

1:13So to that extent, definitely a specialist, but I've never been in the room. So there you go. I rest my case. Katie, we're talking today about three central bank meetings that are all happening this week. Let's go one by one, starting with the Fed, which is the earliest. That's Wednesday. To paint the setup here, U.S. inflation is, by global standards, really not bad, at least at the headline level. It's about 3 % if you include the falling price of energy. It's a bit higher if you look at core inflation, which gets rid of energy and food. In the U.S., we have a lot of, I would say, positive signs about inflation.

1:49You have rent inflation slowing. You have wage growth coming down but not crashing. Unemployment's still low. You have some of the big pandemic anomalies like used cars coming in nicely. There's a lot of things shaping up pretty well for the U.S. economy. And I think you've been seeing in the past couple of weeks, even some of the most bearish people on Wall Street have had to kind of revise up their expectations of where the U.S. economy is going to be. I read a very interesting note this past week from Matthew Luzetti, who's the chief economist at Deutsche Bank. And, you know, he's been like really big in the recession camp for a while.

2:21And he wrote a, I thought, very well considered note, reassessing the case for soft landing, again, from a dude who's been banging the recession drum for quite a while. I think that really captures where the street is at, that there was, and I think still is actually like a two thirds consensus estimate for recession in the next year. That's starting to come down. People are starting to come around and say, the data just looks better. No way around it. Katie, you and I had made a bet on the U.S. economy just a few episodes back. I think you were Q3 2024 was when you thought the U.S. recession was going to be.

2:51I said Q1 and we put a beer on it. I got to say, things are going your direction. I wonder if you're fibbing here, Ethan. I think perhaps you were kind of late this year, but I was definitely later than you. Yeah, you were later than me. That's what matters. And, you know, frankly, Q4, Q1, things really seem to be going your way, not mine. And don't start wriggling now. But yeah, you know, the Fed has already done 500 basis points. That's five of your Earth percentage points of interest rate rises. And it looks like they do another quarter of a percentage point this week. And then we're done. They're going to sit back and gaze upon their works and say, you know, can this be it?

3:32Do we have to do any more? How have we got inflation under control? The tricky thing is that humans have inflation expectations. You know, consumers, people who rent houses, you know, everybody has expectations around where prices are going to go. And so what the Fed will not want to happen is for everyone's inflation expectations to keep sailing higher. So what they're going to have to do is say something along the lines of, OK, we're done for now. Here's another quarter of a percentage point of interest rate rises. But we are absolutely not done yet. We stand ready to act upon any signs of trouble.

4:08And so what you're quite likely to see is the market struggling to figure out which one is the key message from the Fed, I think. Yeah. I'm glad you brought up expectations because this is such a key part of the way central banks think about the world, think about inflation. The way they see it, when you have people thinking about what inflation is going to be in two years, in five years, in 10 years, that has a self-perpetuating nature to it. that if inflation is low and people expect it to be low, it will be low. And if people expect it to be high, it will be high. So when they make these decisions, part of the urgency of raising rates to combat inflation, just for example, comes from the fact that, well, if we lose control of people's expectations, which are a very hard thing to measure, very hard thing to know where they're going, then we really, really lose the fight.

4:54And it becomes quite ugly for the central bank. Yeah. And possibly a neat segue into talking about the next big central bank decision of the week that we have from the European Central Bank, Mario Draghi, who used to run the ECB, used to be president there, was the past master at kind of having people in markets look into his eyes and just have them push the market in the direction that he wanted it to go without necessarily saying out loud, this is what I want you to do. I want the euro lower here. I want the euro higher here. And so there's going to be a certain element of that whereby the policymakers at the Fed and elsewhere just kind of try and hypnotize the market into not getting too carried away.

5:37We don't want like a massive runaway rally in stocks, for example, on the back of the Fed decision, because then all of a sudden you have much easier financial conditions. It gets much easier to borrow and to lend, and then you get the economy overheat even more, and then they have to do more interest rate rises. So very, very delicate. Coming over to the European Central Bank, I mean, very much out of character. They have also raised interest rates very, very significantly over the past year or so. The deposit rate now stands at three and a half percent. It was negative for ages. It cost you money to put money on deposit in the eurozone.

6:13It was kind of mad times. So it's quite interesting because the Fed and the ECB and the Bank of Japan are all at slightly different stages. The ECB is very much a kind of in-betweeny. So it looks like a rise in interest rates from the ECB this week is kind of nailed on. That's what the market thinks is going to happen. September, next time around, very much more debatable. We don't quite know. But it certainly looks like, you know, okay, Eurozone inflation is higher than in the US, but it has come down pretty handily to like five and a half percent. But the business surveys are pretty ugly. We had some quite nasty readings in the past few days.

6:52And so I guess, you know, the bar for them to keep raising rates might be somewhat higher. But, you know, again, they don't want people to get the wrong end of the stick. Right. I think it's worth saying that the ECB is a little bit earlier in the cycle than the Fed is. They started raising rates earlier. And I think they're at a point that the Fed maybe was a couple months ago where they're starting to worry about the so-called lag effects of monetary policy. And this is the idea that it takes time for central bank interest rate increases to spill their way through the economy. There's an entire economic literature about monetary policy transmission.

7:28It's very complicated. It works partially through financial markets, partially through expectations, raising the cost of borrowing in direct ways. There's a lot of proposed channels. But, you know, I think the broad understanding is that it just takes time. And the ECB didn't begin terribly long ago. And maybe you're just now starting to see some of those lagged effects of monetary policy starting to bite. One other wrinkle with the ECB decision is, you know, we were talking about a European recession, what, nine months ago? Saved by weather. Hooray. Yeah. No, there was a warm winter and that really seemed to do it.

8:01Yeah. I mean, one interesting thing on all this as well is, isn't it nice that we're talking about this stuff? So Pictet Wealth Management, they were pointing out in a note the other day that no one's talking about Eurozone fragmentation here. No one's talking about, you know, can Italy tolerate this level of interest rate rises from the ECB? Is this whole project going to fall apart? sometimes it's worth standing back and saying they do seem to have kind of got this situation in hand now it is just nice that we're talking about economics and not eurozone politics and eu politics this is this is purely and simply um an economic story sorry it's picked a wealth management i've only read that word and i've been saying picked it in my head days you americans you see we all learn french at school that's the thing yeah i'm horribly uncultured um every day It's a school day.

8:55Well, now that we've insulted the French. Yes. That's the ECB. Let's talk about Japan. Japan's in a really interesting position. As we've discussed, they're trying to overcome and may really actually be overcoming decades of deflation, which is really a much worse problem for an economy than inflation. Now the question is, when should the central bank exit its ultra-accommodative monetary policy stance that it's maintained for a long time? some of the most interventionist monetary policy we've ever seen, perhaps the most interventionist ever. But it's made more complicated by the fact that Japan is highly dependent on the trajectory of global growth.

9:35It depends on Chinese tourists and on Americans and Europeans buying their cars. And if the global economy starts to slow, that can really have a big impact on Japan's domestic economy. This is in contrast to the US. I mean, the US has such a massive domestic consumer economy that, yeah, I mean, it matters what global growth does, but the US is able to kind of, you know, weather a global economic storm a little bit better than, you know, a more external facing economy like Japan. So now there's this question of Japanese growth really isn't that bad. There's a bit of a manufacturing downturn, but services is picking up.

10:11There's a tourism boom because they reopened to especially the Chinese late last year. But how long is that going to last, given that it looks like global growth is going to soften at least a little bit? And then maybe all the positive inflation dynamics that we've talked about in Japan with higher headline inflation than the U.S., which is just a remarkable statistic. How about that? Maybe that starts to change later this year. Yeah. And it's much more difficult to predict what the Bank of Japan is going to do than the other two central banks we've already spoken about. And what we know from the past is that the Bank of Japan is no stranger to shocking markets.

10:47It likes kind of coming out with pronouncements where nobody's really expecting it. and that they can be consequential for global markets. So if, for example, there is a tweak to what they call yield curve control, if there is effectively a bit of tightening from the Bank of Japan, then that could send the yen shooting higher, for example. And then we will all find out once and for all whether this very handy rally that we've seen in Japanese stocks so far this year really is about the change in corporate governance and all the rest of it out in Japan or whether it is just a yen trade. Yeah, yeah.

11:22Is it just a yen trade with lipstick on? We are going to find out. It's a great point. All right. So we talked about the Fed, the European Central Bank, the Bank of Japan. And we've discussed some of their differences, both economically and the decisions that the central banks face. But we should talk just briefly about maybe what unites them. And to me, looking across the three meetings we have this week, it seems to me that central banks are approaching points where trade-offs become more important, right? In the US, there is a growth versus the speed of disinflation tradeoff. Inflation has come down nicely, but do you really need to push harder to get that last mile in, to get that last percentage point or two off of US core inflation?

12:04Is it worth it? Is it worth it? Does doing that kill some of the huge job market gains, especially for younger people, people of color in the US? I think the European central bank faces something broadly similar. It's different in a European context. They have more rigid labor markets, but the kind of broad growth inflation tradeoff remains the same. And then in the Bank of Japan, I think for a while it was obvious that there's this early stage inflation cycle and they don't want to kill it. That inflation cycle has been going on for some time now. And I think the kind of tweaks that you're discussing, I think those are just on the table because the inflation cycle seems to have some legs.

12:41And yet there's people that say in Japan, well, real wages aren't going up. So can we really believe that this inflation is internally driven at all? I think just, you know, in a way that maybe wasn't true a year ago, you know, the central banks are facing increasingly sharp tradeoffs. Yes, increasingly sharp tradeoffs, increasingly difficult communications, tasks. You know, there's going to be a lot of what we call Kremlinology around central bank communications in the next few days while people try and kind of pick out the true meaning of what they said. You know, Katie, one central bank we did not mention is the central bank of Alphabet and the central bank of Microsoft, both of which report earnings today.

13:20Maybe we'll just save that for the next episode. Okay, done. All right, Katie, we'll be back in a minute with Long

13:36short welcome back it's long short that part of the show where we go long a thing we hate and no we don't that's not it well we go long a thing we love and short a thing we hate i'll get that down eventually katie i i mean oh man i'm i'm short i'm short civilization okay I saw Barbenheimer this weekend or Barbieheimer, whatever the poor man toe is supposed to be. The arc of going from a movie about how this naive fool doomed us all to eventual nuclear extinction to we should solve our emotional problems by buying plastic toys just made me kind of despair. And maybe that's like my grim outlook on life.

14:15And I need to like, you know, cheer up a little bit. And, you know, if listeners would like to send me some happy news, my emails in the show notes. But Katie, I'm sorry to say, I'm short civilization. I need to see these films. I haven't seen them yet. I am breaking the habit of a lifetime and being long UK stocks. One of the things that UK stocks love more than anything else is a weaker pound. And it looks like, I mean, you know, it's a fool's errand to try and predict these things, but it looks like we're probably going to get one, either because the economy is completely balked because of too much interest rate rising from the Bank of England or because the Bank of England keeps on jacking up rates to try and get inflation under control.

14:56It has eased off slightly, but it's still pretty horrible. So, you know, UK stocks have absolutely missed out on the Global Stocks Party so far this year. It's been just we've been left for dust. But it's definitely plausible that we make a late entry here if sterling weakens further. Katie Martin, Long UK Stocks. I have now heard everything. All right, Katie, thanks for being here. We'll see you next Tuesday. And listeners, we'll catch you Thursday in this feed for another episode of Unhedged. See you then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein.

15:33We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, John Schnarz, Eric Sandler, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free, and a 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.